10-Q 1 b40914sse10-q.txt SILVERSTREAM SOFTWARE, INC. SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2001. OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934. Commission file number 000-26981 SILVERSTREAM SOFTWARE, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) Delaware 04-3318325 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) Two Federal Street Billerica, Massachusetts 01821-3559 (978) 262-3000 (Address, Including Zip Code, and Telephone Number, Including Area Code, of Registrant's Principal Executive Offices) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] As of November 9, 2001 there were 22,190,147 shares of the registrant's common stock outstanding. SILVERSTREAM SOFTWARE, INC. FORM 10-Q FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2001 TABLE OF CONTENTS

2 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS SILVERSTREAM SOFTWARE, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands)

The accompanying notes are an integral part of these condensed consolidated financial statements. 3 SILVERSTREAM SOFTWARE, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share data) (Unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements. 4 SILVERSTREAM SOFTWARE, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) (Unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements. 5 SILVERSTREAM SOFTWARE, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. NATURE OF BUSINESS The unaudited condensed consolidated financial statements include the accounts of SilverStream Software, Inc. and its subsidiaries, all of which are wholly owned, located in North America, Europe, Asia and Australia. All intercompany accounts and transactions have been eliminated in consolidation. SilverStream Software, Inc. and its subsidiaries are collectively referred to as the "Company" or "SilverStream." The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and accordingly, they do not include all financial information and disclosures required for complete financial statements pursuant to accounting principles generally accepted in the United States. In the opinion of management, these financial statements include all adjustments necessary for a fair presentation of the results of operations for the interim periods reported and of the financial condition of the Company as of the date of the interim balance sheet. The results of operations for the interim periods are not necessarily indicative of the results to be expected for the full year. SilverStream provides software and services that enable organizations to more effectively do business using the Web. By providing solutions for building, deploying and managing Web-based applications, SilverStream allows companies to deliver applications that have the breadth, depth and richness customers and trading partners expect. The Company markets its software worldwide and has sales offices in the United States, Canada, United Kingdom, The Netherlands, Belgium, Germany, Norway, The Czech Republic, France, Luxembourg, Switzerland, Italy, China, Hong Kong, Singapore, Taiwan and Australia. EARNINGS PER SHARE The Company computes earnings per share in accordance with Statement of Financial Accounting Standard (SFAS) No. 128, "Earnings per Share." SFAS 128 requires calculation and presentation of basic and diluted earnings per share. Basic earnings per share is calculated based on the weighted average number of common shares outstanding and excludes any dilutive effects of warrants, stock options, common stock subject to repurchase or other types of securities. Diluted earnings per share is calculated based on the weighted average number of common shares outstanding and the dilutive effect of warrants, stock options, and related securities calculated using the treasury stock method. Dilutive securities are excluded from the diluted earnings per share calculation if their effect is anti-dilutive. The following table sets forth the computation of basic and diluted loss per share:

The Company has excluded all outstanding stock options and shares subject to repurchase by the Company from the calculation of loss per share because all such securities are anti-dilutive for all periods presented. Shares subject to repurchase by the Company will be included in the computation of earnings per share when the Company's option to repurchase these shares expires. 6 COMPREHENSIVE LOSS Total comprehensive loss was $19.3 million and $64.2 million for the three and nine months ended September 30, 2001, respectively, compared with $7.0 million and $21.3 million for the three and nine months ended September 30, 2000, respectively. Accumulated other comprehensive loss consisted of adjustments for foreign currency translation losses in the amount of $3,000 and $422,000 for the three and nine months ended September 30, 2001, respectively, compared with $343,000 and $477,000 for the three and nine months ended September 30, 2000, respectively. ACQUISITIONS During the nine-month period ended September 30, 2001, the Company acquired three businesses complementary to the Company's business strategy. The aggregate cost of these acquisitions was approximately $8.8 million. Additional consideration, which is contingent upon the operating performance of the acquired business, may amount to $2.1 million and will be recorded as additional purchase price when the contingency is met. These acquisitions have been accounted for using the purchase method and the results of operations have been included in the Company's consolidated statement of operations from the date of acquisition. The excess of the purchase price over the fair value of the net assets acquired has been allocated to goodwill and is being amortized on a straight-line basis over five years. SPECIAL CHARGES During the third quarter of 2001, the Company recorded a special charge of $2.5 million related to the continued restructuring of the Company's operations; specifically, $2.1 million related to a workforce reduction of approximately 125 employees and $400,000 related to office closures. A summary of these charges is as follows:

Future cash outlays for termination benefits are anticipated to be completed by the end of fiscal year 2001, while future cash outlays for office closures will continue through September 2005. During the second quarter of 2001, the Company recorded a special charge of $9.3 million. Of this charge, approximately $7.2 million related to the restructuring of the Company's operations; specifically, $1.5 million related to a workforce reduction of approximately 130 employees and consultants, $4.5 million related to office closures (of which $687,000 represents costs in connection with exiting leased office space in the United States and Europe, such as costs to refit such space for sublease tenants and real estate broker fees for the identification of sublease tenants) and $1.2 million related to the write-down of assets which became impaired as a result of the restructuring. In addition, the Company wrote-down a $2.1 million equity investment which the Company considered to be permanently impaired. A summary of these charges is as follows:

Future cash outlays for termination benefits are anticipated to be completed by the end of fiscal year 2001, while future cash outlays for office closures and costs to exit leased office space will continue through June 2006. The Company continues to review the carrying value of its other long-lived assets and any impairment determined as a result of this review will result in a charge for that period. 7 RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS In the first quarter of 2001, the Company adopted SFAS No. 133, "Accounting for Derivatives and Hedging Activities" as amended by SFAS No. 137 and SFAS No. 138, which establishes accounting and reporting standards for derivative instruments, including derivative instruments imbedded in other contracts (collectively referred to as derivatives), and for hedging activities. The adoption of SFAS No. 133 did not have a material impact on the Company's financial position or results of operations. In July 2001, the FASB issued SFAS No. 141, "Business Combinations" and SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 141 eliminates the pooling-of-interests method of accounting for business combinations, except for qualifying business combinations, and further clarifies the criteria to recognize intangible assets separately from goodwill. SFAS No. 142 eliminates the amortization of goodwill and indefinite lived intangible assets and requires periodic review for impairment. The Company is currently in the process of evaluating the impact SFAS No. 141 and SFAS No. 142 will have on its financial position and results of operations. In October 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." SFAS No. 144 supersedes SFAS No. 121, "Accounting for the Impairment of Long-lived Assets and for Long-lived Assets to be Disposed of" and provides a single accounting model for long-lived assets to be disposed of. The Company is currently in the process of evaluating the impact SFAS No. 144 will have on its financial position and results of operations. LEGAL MATTERS Between June 22, 2001 and August 10, 2001, several purported class action lawsuits were filed in the United States District Court for the Southern District of New York against the Company and several of its officers and directors as well as against the underwriters who handled the Company's August 16, 1999 initial public offering of common stock and its January 25, 2000 secondary offering. The complaints were filed allegedly on behalf of persons who purchased the Company's common stock from August 16, 1999 through and including December 6, 2000. The complaints are similar, and allege violations of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, primarily asserting that there was undisclosed compensation received by the underwriters in connection with the initial and the secondary public offerings. The plaintiffs seek damages and statutory compensation in an amount to be determined at trial plus pre-judgment interest on any such amounts that may be awarded. Although neither the Company nor the individual defendants has filed answers in any of these matters, the Company believes that it and the individual defendants have meritorious defenses to the claims made in the complaints and intends to contest the lawsuits vigorously. RECLASSIFICATIONS Certain amounts from 2000 have been reclassified to conform to the 2001 presentation. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Exchange Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. For this purpose, statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words "believe," "anticipate," "may," "estimate," "continue," "plan," "expect" or the negative thereof and similar expressions are intended to identify forward-looking statements. These forward-looking statements involve risks and uncertainties and are not guarantees of future performance. Actual results may differ materially from those indicated in such forward-looking statements as a result of certain factors including, but not limited to, those set forth under the heading "Certain Factors That May Affect Future Results." All forward-looking statements and risk factors included in this document are made as of the date hereof, based on information available to us as of the date hereof, and we assume no obligation to update any forward-looking statement or risk factors. OVERVIEW We provide software and services that enable organizations to more effectively do business using the Web. By providing solutions for building, deploying and managing Web-based applications, we allow companies to deliver applications that have the breadth, depth and richness customers and trading partners expect. Our solutions leverage the power of standards such as Java and XML to unify relevant information and services for our customers, partners and employees while enabling businesses to leverage prior technology investments. 8 We believe our products and services help our customers to rapidly deliver Web-based applications that are scalable, reliable and secure. Using our products and services, organizations can create and deploy robust Web applications in diverse areas such as business-to-business integration, employee self-service, supply chain management, customer service, and enterprise portals. SILVERSTREAM EXTEND(TM) Our flagship product suite - SilverStream eXtend - is a comprehensive, integrated services environment for building, deploying, and managing services-oriented applications based on J2EE and Web Services standards. Our technology is based on Java, XML and Web Services, and enables customers to accelerate the creation and delivery of Web services-oriented business applications and deliver mission-critical information to any user on any device or platform. SilverStream eXtend leverages the technologies of many J2EE standards-based application servers including the SilverStream eXtend Application Server, IBM(R) WebSphere(R), and BEA(TM) WebLogic(R), and allows customers to unlock the business value of existing systems and deliver relevant information to those who need it when they need it. SilverStream eXtend is made up of four fully integrated components: - SilverStream eXtend Composer (eXtend Composer) - SilverStream eXtend Director (eXtend Director) - SilverStream eXtend Application Server (eXtend Application Server) - SilverStream eXtend Workbench (eXtend Workbench) A brief summary of each component is as follows: EXTEND COMPOSER eXtend Composer allows organizations to integrate a broad range of enterprise systems into Web Services that can be used as the technology foundation of Web-based computing. Regardless of where enterprise information and transactions execute - on mainframes, legacy minicomputers, Unix Servers, databases, or partner Web Services - eXtend Composer's XML integration enables the integration of a broad spectrum of enterprise systems. EXTEND DIRECTOR A true J2EE application, eXtend Director consumes Web Services and delivers relevant, business-driven experiences to every user on any device, regardless of the front end, and puts relevant, real-time information and services into the hands of customers, partners and employees. eXtend Director features intuitive designers and wizards in the eXtend Workbench that make it easier to build sophisticated, services-oriented systems that require workflow, business rules, content management, portal self-service, and delivery to any front end. EXTEND APPLICATION SERVER The eXtend Application Server is a powerful, J2EE-certified platform for building and deploying cross-platform, high performance, standards-based applications. eXtend Workbench and other products of ours, jBroker Web, jBroker MQ, and jBroker ORB, are included with the eXtend Application Server to provide the tools and infrastructure needed to build enterprise applications. The eXtend Application Server is certified with Sun(TM) Microsystems' Compliance Test Suite. EXTEND WORKBENCH eXtend Workbench is a comprehensive environment built to simplify and accelerate the development and deployment of J2EE and Web Services applications. Developers can create a Web Service using wizards and create J2EE deployment plans and descriptors using visual editors in one integrated environment. The above product offerings also include comprehensive application engineering, implementation, training and support services to help ensure the successful implementation of Web applications by our customers. We market and sell our products and services globally through our direct sales force and a network of independent software vendors, systems integrators, consulting partners and distributors. To date, we have licensed our products to more than 1,700 customers in a wide variety of industries, including insurance, communications, financial services, government, manufacturing, oil and gas, pharmaceutical, technology and transportation. 9 We derive our revenue from the sale of software product licenses and from professional consulting, education and technical support services. We plan to generate future revenue from both new and existing customers. As existing customers create new software applications based on the SilverStream eXtend Application Server, they may require more application servers to run these applications. In addition, as existing customers transform existing business systems into Web-based business applications, they may require the entire SilverStream eXtend suite of products to exploit the capabilities of Web Services. We plan to widen our customer base by selling licenses and services to new customers. We anticipate that we will continue to sell annual update assurance and support agreements to most customers. We recognize our software license revenue in accordance with Statement of Position (SOP) 97-2, "Software Revenue Recognition," as amended by SOP 98-4 and SOP 98-9 and with Staff Accounting Bulletin (SAB) 101. SOP 97-2 generally requires revenue earned on software arrangements involving multiple elements to be allocated to each element based on the relative fair values of the elements. We generally recognize revenue allocated to software licenses upon delivery of the software products, provided that (i) we have no remaining significant obligations with regard to implementation, (ii) the license fee is fixed or determinable and (iii) collection of the fee is probable. However, when we sell software product licenses to a reseller, revenue is not recognized until the product is shipped to the ultimate customer. Our customers often contract for update assurance, which provides them with new releases of software for a period of typically one year. These agreements are separately negotiated and priced. We recognize update assurance revenue ratably over this 12-month period. Sales to independent software vendors (ISVs) under our former ISV program were deferred and recognized as product revenue ratably over the anticipated period of performance for services under the agreement, which was generally 12 months. During the third quarter of 2001, we instituted a new ISV program (SilverNet Partner Program). The SilverNet Partner Program is a multiple element arrangement which qualifies for separate element treatment and, accordingly, revenue earned under the SilverNet Partner Program is allocated to each element based on the relative fair values of those elements based on vendor specific objective evidence. Revenue from software products is recognized when the product is delivered, revenue from services is recognized as the services are provided to the customer, and revenue for Postcontract Customer Support is recognized ratably over the term of the agreement. We recognize revenue from the sale of technical support services ratably over the maintenance term and revenue from the sale of consulting and education services as the services are performed. We record cash receipts and billed amounts due from customers in excess of recognized revenue as deferred revenue. Specific contract terms can have a significant impact on the amount of deferred revenue in any given period. Our cost of software licenses revenue includes royalties paid to third parties for technology included in our products, cost of manuals and product documentation, media used to deliver our products and shipping and fulfillment costs. Our cost of services revenue includes salaries and related expenses for our consulting, education and technical support services organizations, costs of third parties contracted to provide consulting services to customers and an allocation of our facilities, communications and depreciation expenses. Our operating expenses are classified into six general categories: sales and marketing, research and development, general and administrative, compensation charge for issuance of stock options, goodwill amortization and special charges. Sales and marketing expenses consist primarily of salaries and other related costs for sales and marketing personnel, sales commissions, travel, public relations, marketing materials, advertising campaigns and tradeshows. Research and development expenses consist primarily of personnel costs to support product development. General and administrative expenses consist primarily of salaries and other related costs for general management, operations and finance employees, legal and accounting services and facilities-related expenses. Compensation charge for the issuance of stock options represents the difference between the exercise price of options granted and the estimated fair market value of the underlying common stock on the date of the grant or the fair value of the award, depending on the facts and circumstances. Goodwill amortization relates to our acquisitions made to support our business strategy. Special charges relate to the restructuring of our operations and the write-down of an impaired investment. Since our inception, we have incurred substantial costs to develop our technology and products, to recruit and train personnel for our engineering, sales and marketing and professional services departments, and to establish an administrative organization. As a result, we have incurred net losses in each fiscal quarter since inception and had an accumulated deficit of $136.2 million as of September 30, 2001. Our limited operating history makes it difficult for us to predict future operating results and, accordingly, there can be no assurance that we will sustain revenue growth or achieve profitability. 10 RESULTS OF OPERATIONS The following table sets forth for the periods indicated the percentage of revenues represented by certain lines in our condensed consolidated statements of operations.

REVENUE Total revenue decreased 38% to $14.6 million in the three months ended September 30, 2001 from $23.5 million in the three months ended September 30, 2000. This decrease is attributable to a lower demand for software licenses and services due to a slower economy. Total revenue increased 7% to $58.2 million in the nine months ended September 30, 2001 from $54.5 million in the nine months ended September 30, 2000. This increase is attributable to an increase in our customer base, the offering of a wider range of consulting services to customers and the release of our newer software products. Revenue from international sales decreased to $7.1 million, or 49% of total revenue, in the three months ended September 30, 2001 from $8.5 million, or 36% of total revenue, in the three months ended September 30, 2000. Revenue from international sales increased to $23.3 million, or 40% of total revenue, in the nine months ended September 30, 2001 from $19.5 million, or 36% of total revenue, in the nine months ended September 30, 2000. The fluctuations in international sales are primarily attributable to the same factors noted above. Software Licenses. Software license revenue decreased 37% to $7.6 million in the three months ended September 30, 2001 from $12.1 million in the three months ended September 30, 2000. Software license revenue decreased 8% to $26.2 million in the nine months ended September 30, 2001 from $28.5 million in the nine months ended September 30, 2000. This decrease is attributable to a lower demand for software licenses due to a slower economy. Services. Service revenue decreased 39% to $7.0 million in the three months ended September 30, 2001 from $11.4 million in the three months ended September 30, 2000. This decrease is attributable to a lower demand for services due to a slower economy. Service revenue increased 23% to $32.0 million in the nine months ended September 30, 2001 from $26.0 million in the nine months ended September 30, 2000. This increase is attributable to the expansion of our professional consulting organization (both internally and through our acquisition of Excelnet Systems Limited, Power 2000 and Bondi Software during 2000), the offering of a wider range of consulting services to customers, and an increase in the number of customers and support contracts. COST OF REVENUE Software Licenses. Cost of software license revenue decreased 87% to $102,000 in the three months ended September 30, 2001 from $760,000 in the three months ended September 30, 2000. Cost of software license revenue decreased 83% to $401,000 in the nine months ended September 30, 2001 from $2.3 million in the nine months ended September 30, 2000. These decreases are attributable to the lower costs associated with our newer SilverStream eXtend products and the fact that they contain fewer sublicensed components than our original Application Server product. We expect software license costs to increase, in conjunction with license revenue, in the future due to additional customer licensing of our products, both domestically and internationally, as well as the licensing of additional third-party technology that we may choose to embed in our product offerings. 11 Services. Cost of service revenue decreased 8% to $9.1 million in the three months ended September 30, 2001 from $9.9 million in the three months ended September 30, 2000. The decrease is primarily attributable to the decrease in demand for consulting services coupled with a reduction in service personnel. Cost of service revenue increased 59% to $37.1 million in the nine months ended September 30, 2001 from $23.6 million in the nine months ended September 30, 2000. This increase is due to additional consulting, education and technical support personnel and to the offering of a wider range of consulting services to customers. Service costs as a percentage of service revenue can be expected to vary significantly from period to period depending on the mix of services we provide, whether such services are provided by us or third-party contractors, and overall utilization rates. In the three and nine months ended September 30, 2001, service costs were higher than service revenue. During these periods, demand for consulting services changed so rapidly that it was difficult to balance consulting resources with demand across geographic regions. As a result, there were regions where demand was so great that consulting subcontractors were engaged to meet customer demand while other regions experienced unforeseen cancellations and delays due to concerns over economic conditions. In these regions, consulting utilization decreased dramatically. In order to lower the cost of services, during the second and third quarter of 2001, we reduced the number of consultants. We will continue to monitor productivity and headcount levels in the upcoming quarters and may incur additional costs to further align our cost structure with our current revenue base. OPERATING EXPENSES Sales and Marketing. Sales and marketing expenses decreased 16% to $9.8 million in the three months ended September 30, 2001 from $11.6 million in the three months ended September 30, 2000. This decrease reflects a reduction in sales and marketing personnel, tighter cost controls, improvements in efficiency and performance and lower commission expense due to the decrease in revenues. Sales and marketing expenses increased 13% to $35.1 million in the nine months ended September 30, 2001 from $31.0 million in the nine months ended September 30, 2000. This increase is attributable to additional sales employees in North America, as well as the expansion of our international sales operations. In order to better align costs with revenue, during the second and third quarters of 2001, we restructured our operations, including our sales and marketing organizations, which resulted in a reduction in the number of sales and marketing personnel. In addition, as noted above, we implemented cost controls and took measures to improve efficiency and performance. As a result, we anticipate that sales and marketing expenses will be lower in the foreseeable future and we will continue to monitor productivity and headcount levels in the upcoming quarters. Research and Development. Research and development expenses increased 11% to $4.9 million in the three months ended September 30, 2001 from $4.4 million in the three months ended September 30, 2000. Research and development expenses increased 41% to $14.9 million in the nine months ended September 30, 2001 from $10.6 million in the nine months ended September 30, 2000. These increases are primarily attributable to additional research and development personnel to support our product development activities. We believe that continued investment in research and development is critical to attaining our strategic objectives, and, as a result, we expect research and development expenses to continue to increase in future periods. General and Administrative. General and administrative expenses increased 10% to $3.2 million in the three months ended September 30, 2001 from $2.9 million in the three months ended September 30, 2000. General and administrative expenses increased 40% to $11.2 million in the nine months ended September 30, 2001 from $8.0 million in the nine months ended September 30, 2000. These increases are attributable to a growing number of administrative employees. We have implemented cost controls and measures to improve efficiency and performance and, as a result, we believe general and administrative expenses will remain at current levels in the foreseeable future. Compensation Charge for Issuance of Stock Options. We incurred charges of $774,000 and $2.3 million for the three and nine months ended September 30, 2001, respectively, related to the issuance of stock options with exercise prices below fair market value on the date of grant. We incurred a charge of $456,000 and $1.2 million in the comparable three and nine month periods ended September 30, 2000, respectively. Additional outstanding options relating to existing stock options granted at less than fair market value will continue to vest over the next three to five years resulting in an aggregate compensation expense of approximately $9.0 million in periods subsequent to September 30, 2001. This additional compensation expense will be amortized to operations ratably over the next five years. Amortization of Goodwill. We incurred charges of $5.2 million and $15.1 million for the three and nine months ended September 30, 2001, respectively, related to the amortization of goodwill. We incurred a charge of $3.4 million and $7.5 million in the comparable three and nine month periods ended September 30, 2000, respectively. Goodwill of approximately $76.0 million in the aggregate will continue to be amortized to operations ratably based on a five-year life and we will continue to review goodwill for impairment. Special Charges. During the second and third quarters of 2001, we implemented overall cost reduction plans due to weakened business conditions. These plans included worldwide staff reductions and the consolidation and/or closing of certain non-profitable offices. As a result, during the third quarter of 2001, we recorded a special charge of $2.5 million related to the restructuring of our 12 operations; specifically, $2.1 million related to a workforce reduction of approximately 125 employees and $400,000 related to office closures. In addition, during the second quarter of 2001, we recorded a special charge of $9.3 million. Of this charge, approximately $7.2 million related to the restructuring of our operations; specifically, $1.5 million related to a workforce reduction of approximately 130 employees and consultants, $4.5 million related to office closures (of which $687,000 represents costs in connection with exiting leased office space in the United States and Europe, such as costs to refit such space for sublease tenants and real estate broker fees for the identification of sublease tenants), and $1.2 million related to the write-down of assets which became impaired as a result of the restructuring. Further, we wrote-down a $2.1 million equity investment which we considered to be permanently impaired. We will continue to evaluate whether any of our long-lived assets have been permanently impaired in view of specific events, changes in operating results and changes in market conditions, and record such impairment when it becomes evident. In addition, as a result of the restructuring, we expect future annual cost savings of approximately $27 million to $29 million. OTHER INCOME, NET Other income, net decreased 50% to $1.7 million in the three months ended September 30, 2001 from $3.4 million in the three months ended September 30, 2000. Other income, net decreased 33% to $6.0 million in the nine months ended September 30, 2001 from $9.0 million in the nine months ended September 30, 2000. These decreases are attributable to a decrease in interest income due to lower interest rates coupled with lower average cash and cash equivalent balances in the comparable three and nine months ended September 30, 2001 versus September 30, 2000. NET OPERATING LOSSES AND TAX CREDIT CARRYFORWARDS As of December 31, 2000, we had net operating losses and research and development credit carryforwards of approximately $49.9 million and $1.4 million, respectively. The net operating loss and research and development credit carryforwards will expire at various dates, beginning in 2012, if not used. Under the provisions of the Internal Revenue Code of 1986, as amended, substantial changes in our ownership may limit the amount of net operating loss carryforwards that can be used annually in the future to offset taxable income. A valuation allowance has been established to fully reserve the potential benefits of these carryforwards in our financial statements to reflect the uncertainty of future taxable income required to use available tax loss carryforwards and other deferred tax assets. LIQUIDITY AND CAPITAL RESOURCES Since inception, we have funded our operations primarily through the private sale of our equity securities, our initial public offering and our secondary public offering with proceeds aggregating approximately $286.9 million. As of September 30, 2001, we had $144.0 million in cash, cash equivalents and marketable securities, and $139.1 million in working capital. We have entered into various lease and financing arrangements which provide for the acquisition of furniture and equipment. At September 30, 2001, we had approximately $271,000 under these arrangements. Such borrowings are secured by substantially all of our tangible assets. Net cash used in operating activities increased to $38.2 million in the nine months ended September 30, 2001 from $15.5 million in the nine months ended September 30, 2000. The increase in net cash used in operating activities reflects increasing net losses off-set by non-cash charges, such as amortization of intangible assets, and changes in operating working capital. Net cash provided by investing activities was $25.3 million in the nine months ended September 30, 2001, as compared to $168.6 million used in investing activities in the nine months ended September 30, 2000. Investing activities reflect purchases of furniture and equipment in each period, as well as the sale and purchase of short-term investments. Investing activities also reflect the acquisition of businesses. Net cash outflows from financing activities was $669,000 in the nine months ended September 30, 2001, as compared to net cash inflows of $193.4 million in the nine months ended September 30, 2000. Cash used in financing activities in the nine months ended September 30, 2001 includes payments on long-term debt offset by proceeds from the issuance of common stock. Cash provided by financing activities in the nine months ended September 30, 2000 includes proceeds from the issuance of common stock, including the secondary public offering in January of 2000, offset by the payments on long-term debt. Capital expenditures decreased to $3.6 million in the nine months ended September 30, 2001 from $8.4 million in the nine months ended September 30, 2000. Our capital expenditures consisted of purchases of computer hardware and software, office furniture and equipment and leasehold improvements. Purchases of computer equipment and leasehold improvements represent the largest component of our capital expenditures. Since inception, we have generally funded capital expenditures either with the use of working capital or equipment bank loans. 13 In September 2001, our Board of Directors authorized the repurchase of up to $10.0 million of our common stock in the open market. Repurchases of stock will be at management's discretion, depending upon acceptable prices and availability. Funds used in the repurchase of shares will come from our existing cash and investment balances along with cash generated from operations. As of November 9, 2001, we have not repurchased any of our common stock. We anticipate that operating expenses will constitute a material use of our cash resources in the foreseeable future. In addition, we may use cash to fund acquisitions of, or investments in, complementary businesses, technologies or product lines. We believe that the net proceeds from the sale of the common stock generated by our initial and secondary public offerings, together with funds generated from operations, will be sufficient to meet our working capital requirements for at least the next 12 months. Thereafter, we may find it necessary to obtain additional equity or debt financing. In the event additional financing is required, we may not be able to raise it on acceptable terms or at all. We do not believe that inflation has had a material impact on our operations. CONVERSION TO EURO Twelve of the fifteen common member countries of the European Union have agreed to adopt the Euro as their legal currency. We have arranged for the necessary modifications of our internal information technology and other systems to accommodate Euro-denominated transactions. In addition, our products support the Euro currency symbol. We are also assessing the business implications of the conversion to the Euro, including long-term competitive implications and the effect of market risk with respect to financial instruments. Based on the foregoing, we do not believe the Euro will have a significant effect on our business, financial position, cash flows or results of operations. We will continue to assess the impact of Euro conversion issues as the applicable accounting, tax, legal and regulatory guidance evolves. CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS The following important factors, among other things, could cause our actual operating results to differ materially from those indicated or suggested by forward-looking statements made in this Form 10-Q or presented elsewhere by our management from time to time. WE HAVE INCURRED SUBSTANTIAL LOSSES, WE EXPECT CONTINUED LOSSES AND CONTINUED LOSSES WILL HARM OUR BUSINESS. We have never been profitable. Our failure to significantly increase our revenue would seriously harm our business and operating results. We have experienced operating losses in each quarterly and annual period since inception and we expect to incur significant losses in the future. We incurred net losses of $28.4 million for the year ended December 31, 2000, $22.3 million for the year ended December 31, 1999 and $12.9 million for the year ended December 31, 1998. As of September 30, 2001, we had an accumulated deficit of $136.2 million. We will need to significantly increase our quarterly revenue to achieve and maintain profitability. If our revenue grows more slowly than we anticipate or if our operating expenses increase more than we expect or cannot be reduced in the event of lower revenue, our business will be materially and adversely affected. WE EXPECT TO DEPEND ON OUR SILVERSTREAM EXTEND(TM) PRODUCT SUITE AND RELATED SERVICES FOR A MAJORITY OF OUR LICENSE REVENUE FOR THE FORESEEABLE FUTURE AND IF OUR SILVERSTREAM EXTEND PRODUCT SUITE DOES NOT ACHIEVE WIDESPREAD MARKET ACCEPTANCE, OUR BUSINESS AND RESULTS OF OPERATIONS WILL SUFFER. We expect to continue to derive a majority of our license revenue from our SilverStream eXtend product suite and related services. Failure to achieve broad market acceptance of SilverStream eXtend, or a decline in the price of, or demand for, our SilverStream eXtend product suite and related services would seriously harm our business and operating results. We cannot predict the level of market acceptance that will be achieved or maintained by our products and services. OUR BUSINESS AND RESULTS OF OPERATIONS WILL SUFFER IF PRODUCT INTRODUCTIONS ARE NOT SUCCESSFUL. We introduced our new SilverStream eXtend product suite to the marketplace during the third quarter of 2001 to enable companies to create Web Services from new and existing systems. The principal components of SilverStream eXtend are the SilverStream eXtend Application Server, SilverStream eXtend Workbench, SilverStream eXtend Composer and SilverStream eXtend Director. It is difficult to predict whether these product components will be successful as the markets for them are at early stages of development. We cannot be certain that SilverStream eXtend will meet customer performance needs or expectations or that it will be free of significant bugs or defects. We also cannot be sure that our third-party distribution partners will actively market SilverStream eXtend, and it will be difficult to track their efforts. Our failure to achieve broad market acceptance of SilverStream eXtend would seriously harm our business and operating results. 14 OUR BUSINESS WILL SUFFER IF WE DO NOT SUCCESSFULLY INTRODUCE ENHANCEMENTS TO OUR CURRENT PRODUCT OFFERINGS. Our future financial performance will depend significantly on revenue from future enhancements to our product offerings that we are currently developing. Any delays or difficulties in completing these enhancements would seriously harm our business and operating results. We have recently released version 3.7 of our SilverStream eXtend Application Server, version 1.1 of our SilverStream eXtend Workbench and version 3.0 of our SilverStream eXtend Composer, and we expect to release version 3.0 of our SilverStream eXtend Director shortly. Version 3.7 of our Application Server brings our server to full J2EE 1.2 compliance. In addition, this release contains new functionality including improvements to the programming environment as well as improved support for computing standards, such as Enterprise JavaBeans and Java2, and third-party development tools. Version 3.0 of our SilverStream eXtend Composer supports the creation, assembly and deployment of J2EE based services-oriented applications, including Web Services, that combine data and transactions from a diverse range of enterprise information systems. Version 3.0 of SilverStream eXtend Director includes J2EE support, deployment on multiple application servers (BEA, IBM and SilverStream), wireless capabilities, enhanced search engine and business user and developer User Interfaces. Version 1.1 of our SilverStream eXtend Workbench supports rapid deployment of J2EE applications packaged as Enterprise Application Archives as well as a number of enhancements required to support the Director and Composer products. We cannot be certain that enhanced versions of the SilverStream eXtend Application Server, SilverStream eXtend Workbench, SilverStream eXtend Composer and SilverStream eXtend Director and other complementary products will meet customer performance needs or expectations when shipped or that new versions will be free of significant software defects or bugs. WE HAVE A LIMITED OPERATING HISTORY SO YOUR BASIS FOR EVALUATING US IS LIMITED. We began commercial shipments of our first software products in November 1997. There are significant risks, expenses and uncertainties that a company like ours faces, particularly in the rapidly evolving Internet market. Because of our limited operating history, our past results and rates of growth may not be meaningful and should not be relied upon as an indication of our future performance. OUR LIMITED OPERATING HISTORY MAKES FORECASTING DIFFICULT AND THE FAILURE TO MEET EXPECTATIONS COULD CAUSE THE PRICE OF OUR COMMON STOCK TO DECLINE. As a result of our limited operating history, it is difficult to accurately forecast our revenues, and we have limited meaningful historical financial data upon which to base planned operating expenses. If we do not achieve our expected revenues, our operating results will be below our expectations and the expectations of investors and market analysts, which could cause the price of our common stock to decline. Specifically, we were founded in May 1996, and began shipping our first products, the SilverStream Application Server 1.0 and related software development tools, in November 1997. We began shipping SilverStream xCommerce 1.0 and ePortal 1.0 in July 2000, which products have evolved into SilverStream eXtend Composer and SilverStream eXtend Director, respectively. Our operating expenses are largely based on anticipated revenue trends and a high percentage of our expenses are and will continue to be fixed in the short-term. The revenue and income potential of our products and business are unproven and the market that we are addressing is rapidly evolving. Our stock price is also subject to the volatility generally associated with Internet, software and technology stocks and may also be affected by broader market trends unrelated to our performance, such as the declines in the prices of many such stocks from March 2000 through the present. In addition, recent terrorist attacks upon the U.S. have added (or exacerbated) economic, political and other uncertainties, which could adversely affect our revenue growth. RECENT TERRORIST ACTIVITIES AND RESULTING MILITARY AND OTHER ACTIONS COULD ADVERSELY AFFECT OUR BUSINESS. Terrorist attacks in New York and Washington, D.C. in September of 2001 have disrupted commerce throughout the United States and other parts of the world. The continued threat of terrorism within the United States and abroad and the potential for military action and heightened security measures in response to such threat may cause significant disruption to commerce throughout the world. Delays or cancellations of customer orders and/or a general decrease in corporate spending resulting from such disruptions could materially and adversely affect our business and results of operations. We are unable to predict whether the threat of terrorism or the responses thereto will result in any long-term commercial disruptions or if such activities or responses will have a long-term material adverse effect on our business, results of operations or financial condition. THE MARKET FOR OUR PRODUCTS IS EMERGING AND OUR BUSINESS WILL SUFFER IF IT DOES NOT DEVELOP AS WE EXPECT. The market for our software products is rapidly evolving and will likely have an increasing number of competitors. We cannot be certain that a viable market for our products will emerge or be sustainable. If the market for our products develops more slowly than 15 expected, our business and operating results would be seriously harmed. THE UNPREDICTABILITY OF OUR QUARTERLY OPERATING RESULTS MAY ADVERSELY AFFECT THE TRADING PRICE OF OUR COMMON STOCK. Our quarterly operating results have varied significantly in the past and will likely vary significantly in the future, making it difficult to predict future performance. These variations result from a number of factors, many of which are outside of our control. Because of this difficulty in predicting future performance, our operating results will likely fall below the expectations of securities analysts or investors in some future quarter or quarters. Our failure to meet these expectations would likely adversely affect the market price of our common stock. Although we have limited historical financial data, we believe that our quarterly operating results may experience seasonal fluctuations. For instance, quarterly results may fluctuate based on our clients' calendar year budgeting cycles, deferral of customer orders in anticipation of product enhancements or new products, slow summer purchasing patterns in Europe and our compensation policies that tend to compensate sales personnel, typically in the latter half of the year, for achieving annual quotas. WE DEPEND ON INCREASED BUSINESS FROM OUR CURRENT AND NEW CUSTOMERS AND ANY FAILURE TO GROW OUR CUSTOMER BASE OR GENERATE REPEAT BUSINESS WOULD HARM OUR OPERATING RESULTS. If we fail to grow our customer base or generate repeat and expanded business from our current and new customers, our business and operating results would be seriously harmed. Many of our customers initially make a limited purchase of our products and services for pilot programs. Many of these customers may not choose to purchase additional licenses to expand their use of our products. Many of these customers have not yet developed or deployed initial applications based on our products. If these customers do not successfully develop and deploy such initial applications, they may choose not to purchase deployment licenses or additional development licenses. Our business model depends on the expanded use of our products within our customers' organizations. In addition, as we introduce new versions of our products or new products, our current customers may not require the functionality of our new products and may not ultimately license these products. Because the total amount of maintenance and support fees we receive in any period depends significantly on the size and number of licenses that we have previously sold, any downturn in our software license revenue would negatively impact our future services revenue. In addition, if customers elect not to renew their maintenance agreements, our services revenue could be significantly adversely affected. OUR MARKETS ARE HIGHLY COMPETITIVE AND OUR FAILURE TO COMPETE SUCCESSFULLY WILL LIMIT OUR ABILITY TO RETAIN AND INCREASE OUR MARKET SHARE. Our markets are new, rapidly evolving and highly competitive, and we expect this competition to persist and intensify in the future. Our failure to maintain and enhance our competitive position will limit our ability to retain and increase our market share resulting in serious harm to our business and operating results. Some of our competitors have longer operating histories and significantly greater financial, technical, marketing and other resources than we do. Many of these companies have more extensive customer bases, broader customer relationships and broader industry alliances that they could leverage, including relationships with many of our current and potential customers. These companies also have significantly more established customer support and professional services organizations. In addition, these companies may adopt aggressive pricing policies, may bundle their competitive products with broader product offerings or may introduce new products and enhancements. OUR LENGTHY SALES CYCLE MAKES IT DIFFICULT TO PREDICT OUR QUARTERLY RESULTS. A customer's decision to purchase our products typically involves that customer's senior information technology managers, because the customer applications to be built and deployed using our products are generally critical to the customer's business. We generally need to educate potential customers on the use, benefits and performance features of the SilverStream eXtend products. Our long sales cycle makes it difficult to predict the quarter in which sales may occur. The sale of our products is also subject to delays from the lengthy budgeting, approval and competitive evaluation processes that typically accompany significant information technology purchasing decisions. For example, customers frequently begin by evaluating our products on a limited basis and devote time and resources to testing our products before they decide whether or not to purchase a license for deployment. Customers may also defer orders as a result of anticipated releases of new products or enhancements by us or our competitors. OUR SALES ESTIMATES ARE SPECULATIVE AND MAY RESULT IN IMPROPER BUDGETING. We use a "pipeline" system, a common industry practice, to forecast sales and trends in our business. Our sales personnel monitor 16 the status of all proposals, such as the date when they estimate that a customer will make a purchase decision and the potential dollar amount of the sale. We aggregate these estimates periodically in order to generate a sales pipeline and compare the pipeline at various points in time to look for trends in our business. While this pipeline analysis may provide us with some guidance in business planning and budgeting, these pipeline estimates are necessarily speculative and may not consistently correlate to revenues in a particular quarter or over a longer period of time. A variation in the conversion of the pipeline into contracts or in the pipeline itself could cause us to improperly plan or budget and thereby adversely affect our business or results of operations. In particular, as was the case in the second and third quarters of fiscal 2001, a slowdown in the economy may cause purchasing decisions to be delayed, reduced in amount or cancelled which will therefore reduce the overall license pipeline conversion rates in a particular period of time. FAILURE TO RETAIN OUR SALES AND MARKETING PERSONNEL WOULD HARM OUR BUSINESS. In order to increase market awareness of our products, market the SilverStream eXtend products to a greater number of organizations and generate increased revenue, our sales and marketing operations need to retain qualified personnel. If we are unable to retain qualified sales and marketing personnel, our business and operating results would be seriously harmed. Our products and services require a sophisticated sales effort targeted at senior information technology management of our prospective customers. New hires require extensive training and typically require at least six months to achieve full productivity. We have limited experience managing a large, expanding and geographically dispersed direct sales force. In addition, we have limited experience marketing our products broadly to a large number of potential customers. WE MAY NOT ACHIEVE THE ANTICIPATED BENEFITS OF OUR RECENT RESTRUCTURINGS In 2001, we restructured our operations through workforce reductions and office closures. Such restructurings could have an adverse effect on our business, and there can be no assurance that we will achieve the anticipated benefits of these restructurings. In addition, there can be no assurance that our workforce reductions will not have a material adverse effect on our business and operating results in the future. FAILURE TO MAINTAIN EXISTING, OR INCREASE THE NUMBER OF, THIRD-PARTY DISTRIBUTION RELATIONSHIPS MAY LIMIT OUR ABILITY TO PENETRATE THE MARKET. We have a limited number of third-party distribution agreements and we may not be able to increase the number of our distribution relationships or maintain our existing relationships. Our failure to increase the number of our distribution relationships or maintain our existing relationships may limit our ability to penetrate the market. FAILURE TO ATTRACT AND RETAIN SKILLED SERVICE PERSONNEL AND ENHANCE OUR SERVICES OFFERINGS WOULD HARM OUR BUSINESS. We believe that growth in our product sales depends on our ability to provide our customers with comprehensive services, including application engineering, implementation, training and support, and to educate third-party resellers, systems integrators and consultants on how to provide similar services. If we fail to attract, train and retain the skilled persons who deliver these services, or fail to educate third-party resellers, systems integrators and consultants on how to provide similar services, our business and operating results would be harmed. We will continue to provide consulting, education and technical support services that complement our products as our installed base of customers grows. Services cost as a percentage of services revenue can be expected to vary significantly from period to period depending on the mix of services we provide, whether such services are provided by us or third-party contractors, and overall utilization rates. WE FACE RISKS ASSOCIATED WITH INTERNATIONAL OPERATIONS THAT COULD HARM OUR BUSINESS. To be successful, we believe we must continue to support our international operations and, therefore, we expect to commit resources to our international sales and marketing activities. However, we may not be able to maintain or increase market demand for our products which may harm our business. We are increasingly subject to a number of risks associated with international business activities which may increase our costs, lengthen our sales cycle and require significant management attention. These risks generally include: - increased expenses associated with customizing products for foreign countries; - general economic conditions in our international markets; - currency exchange rate fluctuations; 17 - unexpected changes in regulatory requirements resulting in unanticipated costs and delays; - tariffs, export controls and other trade barriers; - longer accounts receivable payment cycles and difficulties in collecting accounts receivable; - potentially adverse tax consequences, including restrictions on the repatriation of earnings; and - the risks related to the recent global economic turbulence and adverse economic circumstances in Asia. OUR FUTURE SUCCESS DEPENDS ON CONTINUED USE OF THE INTERNET AND GROWTH OF ELECTRONIC BUSINESS. Our future success depends heavily on the acceptance and wide use of the Internet for electronic business. If electronic business does not continue to grow or grows more slowly than expected, demand for our products and services will be reduced. Consumers and businesses may reject the Internet as a viable commercial medium for a number of reasons, including potentially inadequate network infrastructure, slow development of enabling technologies, insufficient commercial support or privacy concerns. The Internet's infrastructure may not be able to support the demands placed on it by increased usage. In addition, delays in the development or adoption of new standards and protocols required to handle increased levels of Internet activity, or increased governmental regulation, could cause the Internet to lose its viability as a commercial medium. Even if the required infrastructure, standards, protocols and complementary products, services or facilities are developed, we may incur substantial expenses adapting our solutions to changing or emerging technologies. IF WE FAIL TO RESPOND TO RAPID TECHNOLOGICAL CHANGE AND EVOLVING INDUSTRY STANDARDS, OUR PRODUCTS MAY BECOME OBSOLETE. The markets for our products and services are marked by rapid technological change, frequent new product introductions and enhancements, uncertain product life cycles, changes in customer demands and evolving industry standards. New products based on new technologies or new industry standards may quickly render an existing product obsolete and unmarketable. Any delays in our ability to develop and release enhanced or new products could seriously harm our business and operating results. Our technology is complex, and new products and product enhancements can require long development and testing periods. Our failure to conform to prevailing standards could negatively affect business and operating results. IN ORDER TO MANAGE OUR GROWTH AND EXPANSION, WE MUST IMPROVE OUR MANAGEMENT AND OPERATIONAL SYSTEMS ON A TIMELY BASIS. We have expanded our operations rapidly since inception. We intend to continue to pursue existing and potential market opportunities. This pursuit places a significant demand on management and operational resources. Our success depends on implementing additional management information systems, improving our operating, administrative, financial and accounting systems, procedures and controls, training new employees and maintaining close coordination among our executive, engineering, professional services, accounting, finance, marketing, sales and operations organizations. In addition, our growth has resulted, and any future growth will result, in increased responsibilities for management personnel. FAILURE TO RETAIN AND ATTRACT KEY PERSONNEL WOULD HARM OUR BUSINESS. Our success depends largely on the skills, experience and performance of the members of our senior management and other key personnel, including our President and Chief Executive Officer, David Litwack. If we lose one or more of the members of our senior management or other key employees, our business and operating results could be seriously harmed. In addition, our future success will depend largely on our ability to continue attracting, training, motivating and retaining highly skilled personnel. None of our senior management or other key personnel is bound by an employment agreement. Like other software companies in the Boston, Massachusetts area, we face competition for qualified personnel including software engineering, service and support, and sales and marketing personnel. WE INCLUDE THIRD-PARTY SOFTWARE AND TECHNOLOGY IN OUR PRODUCTS AND OUR BUSINESS WOULD BE HARMED IF WE WERE NOT ABLE TO CONTINUE USING THIS THIRD-PARTY SOFTWARE AND TECHNOLOGY. Our products integrate third-party text search, object middleware, compiler, encryption, transaction processing and monitoring, Java virtual machine and database technology and products. There are inherent limitations in the use and capabilities of much of the technology that we license from third parties. Our business would be seriously harmed if the providers from whom we license software and technology ceased to deliver and support reliable products, enhance their current products in a timely fashion or respond 18 to emerging industry standards. In addition, the third-party software may not continue to be available to us on commercially reasonable terms or at all. Many of these licenses are subject to periodic renewal. The loss of, or inability to maintain or obtain this software for any reason could result in significant shipment delays or reductions. Furthermore, we might be forced to limit the features available in our current or future product offerings. Either alternative could seriously harm our business and operating results. Almost all of our products are written in Java and require a Java virtual machine made available by Sun Microsystems in order to operate. Sun may not continue to make the Java virtual machines available at commercially reasonable terms or at all. Furthermore, if Sun were to make significant changes to the Java language or its Java virtual machines, or fail to correct defects and limitations in these products, our ability to continue to improve and ship our products could be impaired. In the future, our customers may also require the ability to deploy our products on platforms for which technically acceptable Java implementations either do not exist or are not available on commercially reasonable terms. WE MAY NOT ACHIEVE THE EXPECTED BENEFITS OF OUR RECENT ACQUISITIONS. During 2000, we acquired Power 2000, Inc., Excelnet Systems Limited and Bondi Software, Inc., providers of e-business services and solutions, and eObject, Inc., the developer of "enTellect", a java based framework for the access, control, personalization and metering of corporate resources. In the nine months ended September 30, 2001, we acquired E-Party Software, a Spanish distributor of our software, Waptop, a Danish wireless technology company, and Beijing SilverSolutions, a Chinese distributor of our software. Our failure to successfully address the risks associated with these acquisitions could have a material adverse effect on our ability to develop and market products based on the acquired technologies. We have just recently developed enhanced features to our SilverStream eXtend products and complementary products based on certain of these acquired technologies, and will continue to devote resources to product development, sales and marketing. The success of these acquisitions will depend on our ability to: - successfully integrate and manage the acquired operations; - retain the necessary software developers and other key employees of the acquired businesses; - develop, integrate and market products and product enhancements based on the acquired technologies; and - control costs and expenses as well as demands on our management associated with the acquisitions. If we are unable to successfully develop and market products and product enhancements as a result of these acquisitions, we may not achieve enhanced revenue or other anticipated benefits from our acquisitions. ANY ACQUISITIONS WE MAKE COULD DISRUPT OUR BUSINESS AND CONSEQUENTLY HARM OUR FINANCIAL CONDITION. In the past, we have acquired businesses with complementary products and technologies and, in order to remain competitive, we may find it necessary to acquire additional businesses, products or technologies. If we identify an appropriate acquisition candidate, we may not be able to negotiate the terms of the acquisition successfully, finance the acquisition, or integrate the acquired business, products or technologies into our existing business and operations. Furthermore, completing a potential acquisition and integrating an acquired business will cause significant diversions of management time and resources. If we consummate one or more significant acquisitions in which the consideration consists of stock or other securities, our stockholders' equity could be significantly diluted. If we were to proceed with one or more significant acquisitions in which the consideration included cash, we could be required to use a substantial portion of our available cash to consummate an acquisition. Acquisition financing may not be available on favorable terms, or at all. In addition, we may be required to amortize significant amounts of goodwill and other intangible assets in connection with future acquisitions, which could seriously harm our operating results. OUR SOFTWARE PRODUCTS MAY CONTAIN ERRORS OR DEFECTS THAT COULD RESULT IN LOST REVENUES, DELAYED OR LIMITED MARKET ACCEPTANCE OR PRODUCT LIABILITY CLAIMS WITH SUBSTANTIAL LITIGATION COSTS. Complex software products like ours can contain errors or defects, particularly when first introduced or when new versions or enhancements are released. Defects or errors in current or future products, including the SilverStream eXtend Application Server Version 3.7, SilverStream eXtend Director Version 3.0 and SilverStream eXtend Composer Version 3.0 could result in lost revenue or a delay in market acceptance, which would seriously harm our business and operating results. We have in the past discovered software errors in our new releases and new products after their introduction and expect that this will continue. Despite internal testing and testing by current and potential customers, our current and future products may contain serious defects. As many of our customers use our products for business-critical applications, errors, defects or other performance problems could result in financial or other damage to our customers and could significantly impair their operations. Our customers could seek 19 damages for losses related to any of these issues. A product liability claim brought against us, even if not successful, would likely be time consuming and costly to defend and could adversely affect our marketing efforts. OUR BUSINESS MAY SUFFER IF WE CANNOT PROTECT OUR INTELLECTUAL PROPERTY. We have two patents issued, four pending U.S. patent applications and one foreign patent application but none may be issued from our existing patent applications. We rely on a combination of contractual provisions, confidentiality procedures, and patent, trademark, trade secret and copyright laws to protect the proprietary aspects of our technology. These legal protections afford only limited protection and competitors may gain access to our intellectual property which may result in the loss of our customers. In addition, despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use our proprietary information. Litigation may be necessary to enforce our intellectual property rights, to protect our trade secrets and to determine the validity and scope of the proprietary rights of others. Any litigation could result in substantial costs and diversion of resources with no assurance of success and could seriously harm our business and operating results. In addition, we sell our products internationally, and the laws of many countries do not protect our proprietary rights as well as the laws of the United States. Our future patents, if any, may be successfully challenged or may not provide us with any competitive advantages. We obtain a major portion of our software license revenue from licensing our products under standardized "click-through" agreements that our customers do not sign. If any of these agreements were deemed unenforceable, those customers may seek to use and copy our technology without appropriate limitations. WE COULD INCUR SUBSTANTIAL COSTS DEFENDING OUR INTELLECTUAL PROPERTY FROM INFRINGEMENT OR A CLAIM OF INFRINGEMENT. Other companies, including our competitors, may obtain patents or other proprietary rights that would prevent, limit or interfere with our ability to make, use or sell our products. As a result, we may be found to infringe on the proprietary rights of others. In the event of a successful claim of infringement against us and our failure or inability to license the infringed technology, our business and operating results would be significantly harmed. Companies in the software market and the Internet market are increasingly bringing suits alleging infringement of their proprietary rights, particularly patent rights. We have been subject to such claims in the past. Any litigation or claims, whether or not valid, could result in substantial costs and diversion of resources with no assurance of success. Intellectual property litigation or claims could force us to do one or more of the following: - cease selling, incorporating or using products or services that incorporate the challenged intellectual property; - obtain a license from the holder of the infringed intellectual property right, which license may not be available on reasonable terms; and - redesign products or services. WE ARE PARTY TO SECURITIES CLASS ACTION LITIGATION WHICH MAY BE COSTLY TO DEFEND AND THE OUTCOME OF WHICH IS UNCERTAIN AND MAY HARM OUR BUSINESS. We and several of our officers and directors, as well as the underwriters who handled our public offerings, are named as defendants in several class action complaints which have been filed on behalf of certain of our stockholders who purchased securities between August 16, 1999 and December 6, 2000. These complaints allege violations of the Securities Act of 1933 and the Securities Exchange Act of 1934. In particular, they allege, among other things, that there was undisclosed compensation received by the underwriters of our initial and secondary public offerings. The plaintiffs are seeking monetary damages, statutory compensation and other appropriate relief. We can provide no assurance as to the outcome of this litigation. Any conclusion of this litigation in a manner adverse to us would have a material adverse effect on our business, financial condition, and results of operations. In addition, the cost to us of defending any litigation or other proceeding, even if resolved in our favor, could be substantial. Such litigation could also substantially divert the attention of our management and our resources in general. Uncertainties resulting from the initiation and continuation of this litigation or other proceedings could harm our ability to compete in the marketplace. Because the price of our common stock has been, and may continue to be, highly volatile, we have no assurance that additional securities class action complaints will not be filed against us in the future. ANTI-TAKEOVER PROVISIONS IN OUR CHARTER DOCUMENTS AND DELAWARE LAW COULD PREVENT OR DELAY A CHANGE IN CONTROL OF OUR COMPANY. Provisions of our certificate of incorporation and bylaws, as well as provisions of Delaware law, could make it more difficult for a 20 third party to acquire us, even if doing so would be beneficial to our stockholders. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We do not currently use derivative financial instruments. We generally place our marketable security investments in high credit quality instruments, primarily U.S. Government and Federal Agency obligations, tax-exempt municipal obligations and corporate obligations with contractual maturities of ten years or less. We do not expect any material loss from our marketable security investments and therefore believe that our potential interest rate exposure is not material. Internationally, we invoice and receive payment from customers primarily in local currency. We are exposed to foreign exchange rate fluctuations in the rare case when customers are invoiced in local currency and payment is received in a currency other than local currency. We do not currently enter into foreign currency hedge transactions. Through September 30, 2001, foreign currency fluctuations have not had a material impact on our financial position or results of operations. Investments in both fixed rate and floating rate interest earning instruments carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. Due in part to these factors, our future investment income may fall short of expectations due to changes in interest rates or we may suffer losses in principal if forced to sell securities that have experienced a decline in market value due to changes in interest rates. A hypothetical 10% increase or decrease in interest rates, however, would not have a material adverse effect on our financial condition. Interest income on our investments is carried in "Other income, net." We account for cash equivalents and marketable securities in accordance with Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." Cash equivalents are short-term, highly liquid investments with original maturity dates of three months or less. Cash equivalents are carried at cost, which approximates fair market value. Our marketable securities are classified as available-for-sale and are recorded at fair value with any unrealized gain or loss recorded as an element of stockholder's equity (deficit). PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS Between June 22, 2001 and August 10, 2001, several purported class action lawsuits were filed in the United States District Court for the Southern District of New York against us and several of our officers and directors as well as against the underwriters who handled our August 16, 1999 initial public offering of common stock and our January 25, 2000 secondary offering. The complaints were filed allegedly on behalf of persons who purchased our common stock from August 16, 1999 through and including December 6, 2000. The complaints are similar, and allege violations of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, primarily based on the assertion that there was undisclosed compensation received by the underwriters in connection with the initial and secondary public offerings. The plaintiffs seek damages and statutory compensation in an amount to be determined at trial plus pre-judgment interest on any such amounts as may be awarded. Although neither we nor the individual defendants have filed answers in any of these matters, we believe that SilverStream and the individual defendants have meritorious defenses to the claims made in the complaints and intend to contest the lawsuits vigorously. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS (d) Use of Proceeds from Sales of Registered Securities On August 20, 1999 we closed our initial public offering of our common stock. The shares of common stock sold in the offering were registered under the Securities Act of 1933, as amended, on a Registration Statement on Form S-1 (Registration No. 333-80553) that was declared effective by the Securities and Exchange Commission on August 16, 1999. After deducting the underwriting discounts and commission and the offering expenses, we received net proceeds from the offering of approximately $49.6 million. On January 31, 2000, we closed a secondary public offering of our common stock. The shares of common stock sold in the offering were registered under the Securities Act of 1933, as amended, on a Registration Statement on Form S-1 (Registration No. 333-94103) that was declared effective by the Securities and Exchange Commission on January 25, 2000. After deducting the underwriting discounts and commission and the offering expenses described above, we received net proceeds from the offering of approximately $191.7 million. 21 The net proceeds generated from the initial and secondary public offerings have been used primarily to fund our working capital, capital expenditures and general corporate needs. In addition, we used $9.1 million as payments related to the acquisition of ObjectEra, and we made a loan of $2.0 million to one of our corporate collaborators pursuant to a convertible promissory note, which was converted to an equity investment on May 31, 2000. As part of the consideration for the purchase of eObject, we made a payment of $1.0 million. In connection with the purchase of Power 2000, we made a payment of $5.3 million, as well as a payment of $665,000 to pay off Power 2000's line of credit, a liability we assumed as part of the purchase price. As part of the consideration for the purchase of Excelnet Systems, we made a payment of $3.5 million. We also made payments of $500,000 during December 2000 and $5.4 million during January 2001 for the purchase of Bondi Software. During the three months ended March 31, 2001 we made payments of $930,000, $1 million and $150,000 as part of the consideration for the purchase of E-Party Software, Waptop, and Beijing SilverSolutions, respectively. Our capital expenditures included $3.9 million related to the relocation of our corporate headquarters from Burlington, Massachusetts to Billerica, Massachusetts. Specifically, we incurred approximately $1.4 million on furniture, fixtures and office equipment, $760,000 on computer equipment and $1.7 million on leasehold improvements in connection with the relocation. Remaining proceeds from the secondary public offering are currently invested in U.S. Government and Federal Agency obligations, tax-exempt municipal obligations and corporate obligations with contractual maturities of ten years or less. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits 10(1) Separation Agreement dated August 31, 2001 between SilverStream Software, Inc. and Robert Morris. (b) Reports on Form 8-K. No reports on Form 8-K were filed during the quarter ended September 30, 2001. 22 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Dated: November 9, 2001 SILVERSTREAM SOFTWARE, INC. By: /s/ Craig A. Dynes --------------------------------- Craig A. Dynes Vice President, Chief Financial Officer, Secretary and Treasurer (Principal Financial Officer and Chief Accounting Officer) 23

SILVERSTREAM SOFTWARE INC 10-Q